Formalization of management control systems in fast growing organizations;
To do or not to do?
Abstract
Purpose of this research – The purpose of this research is to examine how managers in fast growing organizations implement formal management control systems (MCS).
Methodology – A single case study will be used for this research. The case study focuses on a fast growing organization in the Telco industry. Interviews with managers from different departments of this organization will be analyzed.
Findings – MCS are formalized in a dissimilar way. The degree of formalization depends on task characteristics. A higher degree of formalization is implemented for repetitive and analyzable tasks. The formalization of MCS is limited when an operating environment quickly changes and asks for a flexible approach. When the founders believe their organization is unique and incomparable to other organizations, they apply a reactive approach in formalizing MCS.
Limitation of the research – Limitations of this research concern the use of a single case study and a limited dataset. Therefore research on other fast growing organizations is needed to generate a more generic view on how formal MCS is implemented in fast growing organizations. Further research on the organization examined in the dataset is needed in a few years’ time, to gain knowledge about the next steps in the implementation process of formal MCS within a fast growing organization.
a well-functioning example and a quickly changing operating environment, formal MCS is implemented in a reactive way.
Value of this research – This research contains empirical evidence about how managers in fast growing organizations implement formal MCS. Furthermore, this research extends prior research on drivers of formalization, as multiple new drivers of formalization have been found.
Keywords – Management control systems (MCS), formalization, fast growing organizations.
Introduction
Over the past few years there has been an enormous increase in so-called hypergrowth organizations (Valencia, 2019). According to Valencia (2019) hypergrowth refers to organizations that grow explosively, whereby the annual growth rate exceeds 40%. This differs from organizations that go through periods of slower and more stable growth. Hypergrowth can therefore be seen as a huge challenge, as these fast growing organizations need to act quickly to ensure that they have the right systems and employees in the right place. If they do not have control over this situation, the organization can quickly fall apart (Valencia, 2019).
is questionable (Ferreira and Otley, 2009). When the operating environment and the amount of growth differs from other organizations, the possibility of the organization fitting in a static framework is relatively small (Ferreira and Otley, 2009).
Just like organizations that experience stable growth, fast growing organizations face growing pains of control (Flamholtz and Randle, 2007). When an organization faces growing pains of control, the transition from informal to formal MCS has to be made to avoid a stage of inertia (Flamholtz and Randle, 2007). But to be able to react quickly to their operating environment, fast growing organizations also have to be innovative. According to existing literature (Ouchi, 1979; Damanpour, 1991), there is a negative relationship between the formalization of MCS and innovation. Miner et al. (2001) state that a combinational use of both informal and formal control is most functional. As formal control can provide a stable background for other more innovative and informal processes. Therefore fast growing organizations that rely on further innovation face challenges regarding the degree of formalization within their organization.
Other existing research focuses on the difficulties in the implementation process of formal MCS in fast growing organizations. According to Garengo et al. (2005) the biggest challenges in the implementation process of formal MCS are the lack of managerial capacity and the experience of the entrepreneurs. But as Garengo et al. (2005) mention, empirical evidence in support of theoretical findings regarding the implementation of formal MCS in fast growing organizations is needed.
MCS. As some literature states that implementation of formal MCS is needed (Flamholtz and Randle, 2007) others state that a combinational use of formal and informal MCS is more functional (Miner et al., 2001). Empirical evidence could help in supporting theoretical findings about how MCS are implemented within a fast growing organization. It is also unknown how managers in a fast growing organization know “how” and “when” to implement formal MCS. Empirical evidence could help in describing how the formalization process of MCS takes place in a fast growing organization. This could extend current literature about drivers of formalization. Davilla (2005) states that the size of an organization, the age of an organization, the appointment of a new CEO, and venture capital are drivers of formalization. But it is unclear what the drivers of formalization are in a fast growing organization.
In this research a dataset of semi-structured interviews will be used. Employees in different departments of a fast growing organization in the Telco industry have been questioned in these interviews. The research question will be answered by collecting the experiences of these managers with regard to the implementation of formal MCS.
Theoretical background
Management control systems
Management control systems (MCS) have a very important function in organizations. Failures regarding management control can lead to enormous financial losses, reputational damage, and in extreme cases even failure of the organization (Merchant and van der Stede, 2012). Langfield-Smith (1997) states that MCS can be used by managers to obtain and use resources effectively and efficiently to achieve organizational objectives. Flamholtz and Randle (2007) describe MCS as a mechanism to help manage the performance of people in organizations.
The needs for MCS arise because of problems regarding: a lack of direction, motivational problems, and personal limitations (Merchant and van der Stede, 2012). Furthermore Merchant and van der Stede (2012) claim that the maintenance of good management control leads to a high probability of organizational success. Good control is when the management of an organization is relatively confident that no unpleasant surprises will occur (Merchant and van der Stede, 2012). MCS are quite costly, hence, organizations have to think about a cost effective way of implementing MCS. Therefore it is important that organizations implement MCS when the cost of implementation is lower than the potential loss of money when the MCS is not implemented, the so-called control loss. Organizations must strive for adequate control instead of perfect control (Merchant and van der Stede, 2012).
are less objective and uncodified forms of control (Kreutzer et al, 2016).
Sitkin et al. (2010) state that traditional research on MCS focuses on formal and informal control as substitutes. An example of this traditional research can be found in the studies of Ouchi (1977, 1999). Ouchi (1979) defines three different forms of control mechanisms. The first form is formal behavior control which concerns explicit procedures that must be followed, such as the monitoring of ongoing activities. The second control mechanism is formal outcome control which focuses on results of the organizational activities. The last control mechanism defined by Ouchi (1979) is informal clan control. Informal clan control consists of selection and socialization mechanisms that can be used to establish and preserve organizational culture, norms, and values.
More recent research on MCS shows that formal and informal control can be better defined as different dimensions of control rather than substitutes. Besides formal behavior control and formal outcome control, informal behavior control and informal outcome control are also defined by Sitkin et al.(2010). The similarity between formal and informal control is that both forms are hierarchical, organizational, and intentional. The distinction between formal and informal controls can be made by looking at their visibility and explicitness (Kreutzer et al., 2016). An example can be given by looking at formal outcome control and informal outcome control. Formal outcome control concerns cost budgets, deadlines, and goals where informal outcome control is directed at the results of behavior. Informal outcome control can be executed through the use of verbal encouragement and praise for achieving goals. Formal outcome control is very explicit and visible in the organization in contrast to the informal outcome control (Kreutzer et al., 2016).
employees and management. Second advantage is that the use of both informal and formal control leads to an increase in cooperation between initiative employees and management. Third and last advantage mentioned is that the complementary use of both informal and formal control offer opportunities to mitigate limitations and deficiencies of relying only on one of the two forms of control (Kreuzer et al., 2016).
organizations more challenging is that these organizations often operate in quickly changing environments. According to Merchant and van der Stede (2012), MCS must be implemented more loosely in such organizations as actions are less programmable. Therefore for some organizations it is much more effective to combine formal and informal controls. In this way, there is still room for control through social mechanisms, which leads to a more adaptive workforce that is stimulated to solve problems and implement solutions (Merchant and van der Stede, 2012).
Transition from informal to formal control
Garengo et al. (2005) mention multiple reasons for problems in the implementation process of formal MCS. For starters, small organizations have a lack of human resources. Staff is focusing on daily work and very often have insufficient time for the implementation of MCS. The second problem is the managerial capacity. In the starting period of fast growing organizations, there is a lack of managerial culture. This leads to undervaluation of the presence of managerial tools and techniques. The third difficulty is the lack of capital resources, as the implementation of formal MCS can be costly. The fourth problem is the reactive approach, often maintained in smaller organizations. The organizations do not use strategic planning and rely on an informal decision-making process. The Fifth problem in the implementation process is tacit knowledge and the little attention given to the formalization of processes. This is caused by the fact that there is absence of formalized management processes and a lack of managerial processes. When this is the case, the information that needs to be gathered for formal MCS is difficult to gather. Last problem is the misconception of MCS. Smaller organizations tend to see MCS as a cause of bureaucratization and an obstacle to flexibility and do not see potential advantages of the implementation (Garengo et al.,2005).
for the implementation of formal controls within their organizations. The application of control systems in an organization must be of adding value to the organization (Merchant and van der Stede, 2012). Especially in fast growing entrepreneurial organizations some considerations have to be made. According to Ouchi (1979) the use of management control systems can stifle innovation. Damanpour (1991) found out that there is a negative relationship between formalization and innovation, which forms a challenge for entrepreneurial fast growing organizations. Formal control systems can be used best in situations where task analyzability is high and the number of exceptions low (Perrow, 1970). More recent research shows that innovation benefits from a balance between formal and informal controls (Davilla et al., 2007). According to Miner et al. (2001) routines and formal control systems provide a stable background for innovative and more informal processes within an organization. In existing research on the combinational use of informal and formal control there is controversy in theories about the combinational use of informal and formal control. Whereas Flamholtz and Randle (2007) mention that a transition from informal to formal control has to be made to avoid a stage of inertia, others (Davilla et al., 2007; Miner et al., 2001) mention that a combinational use might be most effective for innovative companies. But empirical evidence is still needed to contribute to this research.
the transition from informal to formal MCS has to be made or if fast growing organizations that rely on innovation benefit more from the combinational use of formal and informal control. Existing literature can be further developed by finding out if there are more drivers of formalization than currently discovered. Last theoretical challenge of this research is to check if the theories made about implementation of formal MCS are applicable in the operating environment of fast growing organizations. As Garengo et al. (2005) state, empirical evidence is needed in support of theoretical findings. Existing research on this topic focuses either on medium or large organizations or fast growing organizations in processing industries (Davilla, 2005). It is unclear if current static frameworks designed for medium and large organizations are applicable for fast growing organizations. Fast growing organizations in different environments and experiencing different growth curves, could possibly be a bad fit in static frameworks defined for completely different organizations (Ferreira and Otley, 2009). The challenge from an empirical viewpoint is to see how the implementation takes place in a practical case. Thereby answers need to be found on how managers identify the need to implement formal controls and how these managers know “how” and “when” to start implementing these formal controls.
This leads to the following research question:
‘How do managers in fast growing organizations implement formal MCS?’
Research methods
To explore how managers in fast growing organizations implement formal MCS, a single case study will be used. Since this research method helps in answering “how” and “why” questions, it is an appropriate way to find an answer on the research question of this paper (Voss et al., 2002). The data used for this research is collected from an already-existing dataset. The organization that will be analyzed is Phone Inc..
Case study description
The case used for this research is that of Phone Inc.. Phone Inc. is an organization that operates in the telco industry and sells phones, and phone subscriptions via E-commerce and in their stores located in the Netherlands. In the last few years Phone Inc. experienced rapid growth which caused a lot of challenges for the management of Phone Inc. and increased the urge to formalize MCS in their organization. To explore how managers in fast growing organizations implement formal MCS, the case of Phone Inc. will be used to gain knowledge about this process by using the experiences of the Phone Inc. management on how they formalized MCS within Phone Inc..
Data gathering process
and therefore select interviewees from different departments. The organization of Phone Inc. consists of seven departments. Due to the limitation of six interviews, one department cannot be interviewed. Therefore it is important to select an interview that is best able to cover two departments. Within the operating departments of Phone Inc. there is a team leader subscriptions. Furthermore there is a separate coordinator regarding the subscription process. By selecting the team leader subscriptions for the team leaders department, some knowledge of the subscription process will be picked up and the interview with the coordinator subscriptions could be left out. Between the other departments there were bigger differences regarding their function whereby one interview could impossibly cover two functions. The definitive selection (see table 1.1) can therefore be seen as a selection that shows experiences regarding the formalization process of MCS from all the different possible viewpoints within the organization of Phone Inc.. This wide viewpoint of experiences can lead to a general viewpoint formed by all the different inputs of the different managers and explains how they choose to implement formal MCS.
1.1 Possible interviewees / In bolt the interviews that were selected for this research.
Analysis
informal and formal forms of MCS that exist in the organization. The second-order codes that have been distinguished are six major components that overarch the first-order codes. In the last step of the codification process, three themes are formulated. These three themes are the main contribution in answering the research question and show how formal MCS are implemented, but also show which factors determine the degree of formalization within Phone Inc..
1.2 Coding structure of MCS in Phone Inc..
Findings
of quotes will be included to support these second-order codes. At the end of each paragraph empirical evidence for the main theme will be discussed. This leads to evidence for the three major themes that arise from the interviews and reflect the main contributions to current literature.
Dissimilarity. Within the organization of Phone Inc. there is a clear separation in formality regarding MCS between the operational departments and the supporting departments. The operational departments work with standard operating procedures, some tasks are automated, functions are specialized, and there are clear operational targets. Training programs have been developed to help new employees in learning and developing skills that are needed to perform their job and there is a segregation of duties. “In the operational department functions are segregated into three different levels. For every different level there are specific training programs and whenever employees reach a higher functional level, they receive a higher salary” (Team leader subscriptions and development). These factors increase the efficiency in the operating departments and create self-managing departments. Whereas the employees of the supporting departments (Purchasing, finance, performance specialists, and business development) have a lot more freedom in their functioning and there is a lack of formality in MCS. There are no different functional levels and founders are directly involved in leading these departments. The formal MCS that are present in the supporting departments are weekly/monthly reports on the progress made and written out working routines to help new employees and archive knowledge. “In contrast to operational departments, there are no managers in the supporting departments but every department has a so-called point of contact, often an employee with the most working experience but there is no difference in rank and tasks are often rotated for motivational purposes. ” (Executive controller F&C).
crystallized whereas the activities faced by supporting departments are very specific and ask for a more customized approach” (Founder). These examples show that managers implement formalization in different ways among the organization. When tasks can be easily elaborated and task analyzability is high, formal MCS are implemented in an earlier stage. In departments with more working freedom, founders of the organization keep intimately involved with the working process and there is a lack of formalization. The formal MCS that are present in the supporting departments, mainly focuses on reporting and documentation about the tasks that are executed.
1.3 Empirical evidence for the first theme
P1. Difference in tasks characteristics lead to dissimilarity in the degree of formalization of MCS in an organization.
Through the dynamic environment, Phone Inc. takes a reactive approach and long-term vision is not useful.
Another important factor to maintain a high level of flexibility is the informal culture of Phone Inc. There is a culture of open and direct communication within the organization, most employees in the supporting departments even have direct contact with the founders. Employees are given a lot of freedom and trust and they are ought to learn their job by doing and learning from their mistakes: “Employees get freedom and responsibilities, these responsibilities increase when you prove your worth within the organization” (Business Developer) . Furthermore employees in the supporting departments are motivated intrinsically: “I see it as my challenge to do my job in the most optimal way” (Pricing & Category manager). In the recruiting procedures of Phone Inc. the importance of recruiting new employees with the same mindset is important. When people cannot cope with the freedom and are not motivated, social control is used to detect this: “When people are behaving in such a way that they do not function in the way we expect from them, we will notice this” (Business Developer). The open and informal culture creates a solid base for flexibility of the organization.
flexibility in the organization that is needed to react quickly to changes in the operating environment. At this moment of time, while the organization can function in this way, the informal approach in some organizational parts gives the organization an advantage with respect to their competitors.
1.4 Empirical evidence for the second theme
P2. The flexibility that is needed to operate in a fast changing environment ensures that there is a limit in formalization and means that some business processes remain informal to be able to react quickly to changes in the operating environment
how to manage such an organization. Therefore the influence of founders but also their beliefs of how to manage their organization is leading and founder involvement is higher.
1.5 Empirical evidence for the third theme
P3. When founders believe their organization is unique and incomparable to other organizations, they limit the formalization process and remain highly involved.
Discussion and conclusions
The purpose of this research is to find out how managers in fast growing organizations implement formal MCS. This study extends current literature about the combinational use of formal and informal control, and checks if the current theoretical principles are applicable in practice. Furthermore the aim of this research is to bring a new perspective on existing literature by examining how formalization of formal MCS occurs in fast growing organizations.
There are three main contributions to existing theory. The first contribution is about the dissimilarity in the degree of formal MCS within an organization. This study shows that in practice, the formalization process takes place in phases whereby an organization will start with formalizing processes in departments where task analyzability is high and tasks can be easily elaborated. In departments where tasks ask for a more customized approach, only the standard procedures are documented and reports about progress are made. But there is a lack of formalization in these departments, as tasks are less crystallized.
environment of an organization. Fast growing organizations that operate in a fast changing environment have to be flexible to adapt to changes in their operating environment. Therefore formalizing too many processes and creating a bureaucratic organization may lead to losing a competitive advantage. As examined in this study, the fast growing organization experiences a lot of benefits of some informal features of control within the organization in comparison to bureaucratic competitors. Hence, when the operating environment asks for a flexible approach, the organization will benefit when some processes like organizational culture are informal and employees have decision making freedom.
The third contribution concerns the way the founders of an organization are involved in the organization and how their beliefs limit the formalization of MCS. In the beginning stages of an organization, the beliefs of the founders are leading. Therefore they decide which process to formalize and how and when they want to formalize these processes. In the case of Phone Inc. the view of the founders is that they want to limit the amount of managers within the organization and want to keep the organizational structure as flat as possible. Furthermore the founders see their organization as a unique organization without a well-functioning example that can be used. They believe a reactive approach of implementing formal MCS is best due to the operating environment and the absence of a well-functioning example of similar organizations. The sets of beliefs from the founders in the case of Phone Inc. lead to higher founder involvement and therefore to a limitation in the formalization process of MCS.
reports about progress and written out working routines, these documents focus on organizational learning. This outcome is in line with Levitt and March (1988) that state that organizational learning is an important urge for the implementation of MCS. In line with current literature on the combinational use of informal and formal control (Miner et al., 2001; Davilla et al., 2009; Merchant and van der Stede, 2012) this research shows that a stable background of formal controls in the operating departments, creates a solid background for more innovative processes that are present in the supporting departments. The extension on current research can be found in the driver of formalization that can be derived from this contribution and the empirical evidence on how managers in fast growing organizations implement formal MCS. Current research on drivers of formalization (Davilla, 2005) states that the size of the organization, the age of the organization, the appointment of a new CEO, and venture capital are drivers of formalization. This research shows that the characteristics of tasks also influence the formalization of MCS. When tasks are analyzable and have a repetitive character formalization of MCS will take place in an earlier stage whereas for departments with non-repetitive tasks, formalization of MCS is adopted in a later stage. Furthermore this first proposition answers partly how managers in fast growing organizations implement formal MCS. In current literature the main focus was on medium and large organizations (Davilla, 2005). This research gives empirical evidence that managers in fast growing organizations start with the implementation of formal MCS in departments where tasks are repetitive and analyzable. Other formal forms of MCS that are implemented in the beginning stage of a fast growing organization focus on organizational learning.
also the appointment of a new CEO and venture capital as drivers of formalization. The second proposition describes the importance of the operating environment of the organization. In this research, the organization that was examined experienced a lot of benefits from their flexible approach. Because their competitors had a more bureaucratic organization, Phone Inc. gained a competitive advantage by being able to react quickly due to their informal decision making and their informal culture. When the operating environment shows that such an approach is profitable, this will limit formalization because organizations do not see the utility of implementing formal MCS in these processes of the organization. Therefore the operating environment can be seen as a driver of formalization but simultaneously as a limitation of this process, when the operating environment asks for a flexible approach.
of formalization is a constant process where founders of an organization remain highly involved to check what to formalize at a certain point of time. So besides giving evidence for the theory of Garengo et al. (2005) this research also shows shortcomings in this theory as the uniqueness of an organization can lead to a decrease in usefulness of theoretical findings discovered by Garengo et al. (2005). Furthermore this third contribution adds more empirical evidence on how managers in fast growing organizations implement formal MCS and how these managers know when to implement formal MCS. As stated before current literature mainly focuses on medium and large firms (Davilla, 2005). Therefore empirical evidence on how managers in fast growing organizations implement formal MCS extends current literature. This contribution gives empirical evidence that managers apply a reactive approach and what they formalize depends on what is the most urgent at a certain moment of time.
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